Question

What is a depreciation tax shield, and how does it affect capital budgeting decisions?

Answer 1

Depriciation tax shield -

Depriciation expense is considered as a shield to reduce tax. Depriciation expense reduce the tax liability of a taxpayer. Higher the Depriciation, lower will be the taxable profit. This is the reason, depriciation acts as a shield from tax. The amount of tax which is saved by depriciation is =

Depriciation amount × Applicable tax rate

Depriciation tax shield affects the capital budgeting decisions in a positive manner. Since, depriciation reduces taxable profit, it is advisable to use depriciation in an investment in asset. In other words, we can say, it is not an actual expense, no real cash outflow is involved, still it helps to reduce tax liability. But for calculating final cash flows, depriciation is added back in net cash flow, as depriciation is a non cash expense.

The most beneficial depriciation method is accelerated depriciation method, since it allows a large amount of depriciation as a reduction from income during first initial years of period of fixed asset. Amount of depriciation may differ between books of accounts and as per income tax calculations, due to difference in depriciation method used and method allowed for tax purpose or difference in depriciation rates for accounting and tax purpose.